Strategic Management/ Business Policy Power Point Set #2 Performance Measurement

Fundamentals of Competitive Strategy Superior Long-Run Performance The central goal Attractive Industry Structure Competitive Advantage High returns for the average participant Outperform the average industry participant Superior Competitive Position Operational Effectiveness Do different things than rivals Do the same things as rivals but better

Economic Profits and Competitive Advantage Driving a wedge between revenues and costs is how competitive advantage is created. In strategy, we need to think simultaneously about: The value we create for our customer; How we appropriate some of that value in terms of higher prices; The costs we incur in creating that value. Conceptual traps that managers fall into: Accounting Costs versus Opportunity Costs Market Share is not competitive advantage

The First Rule of Strategy A Good Strategy Is “Coherent.” Functional pieces of strategy support the whole (Michael Porter: HBR, 1996) Oper. Strategy Finance Acctg. H.R. Mktg.

Strategic Coherence The Logic of How The Business Fits Together: Southwest Airlines Low Price Short Routes No Frills Point-to-Point One Aircraft -- Boeing 737 High number of Aircraft per Route No Meals Flexible/ Lower Staffing American Airlines Premium Price Short, Long, & Int’l Variety Hub & Spoke System Multiple Aircraft Low number of Aircraft per Route Meals & Service Higher Staffing

Opportunities & Threats Values Of Stakeholders SWOT Analysis Strengths, Weaknesses, Opportunities, and Threats Strengths & Weaknesses Opportunities & Threats Values Of Management Values Of Stakeholders Strategy Internal Factors External Factors Drivers Objectives

How Do We Measure Performance? “The strategic aim of a business is to earn a return on capital, and if in any particular case the return in the long run is not satisfactory, then the deficiency should be corrected or the activity abandoned for a more favorable one.” Alfred P. Sloan My Years with General Motors

Sustainable Competitive Advantage and the Measurement of Performance While we have said that the objective of strategy is to “create competitive advantage,” specifically we have the goal to maximize economic return. Economic & Accounting Measures of Performance Economic Profits ROA, ROE, ROC Financial Measures of Performance NPV Methods

Financial Measures of Performance: NPV or DCF Analysis The principle of discounted cash flow (DCF) analysis that firms apply to their individual projects can also be applied to the firm as a whole. Maximizing the net present value of the firm’s cash flow (“sustainable competitive advantage”) corresponds to maximization of its stock market valuation and hence maximizes the wealth of its shareholders.

Net Cash Flow EBT - t (EBT) EBT (1-t) = NET INCOME EBT (1-t) + depreciation - capital expenditures = NET CASH FLOW (note we are assuming no change in accounts receivable, no change in net working capital, no change in inventory) Equivalent concepts: Maximize NPV DCF Approach Maximize Economic Profits (EVA) Sustainable Competitive Advantage (SCA)

Limitations of Present Value Measures Projections are only as good as the ability of managers to measure accurately the financial consequences of actions. An implicit assumption of value-based strategy was that business units and all investment proposals were self-contained. It was usually expected that divesting a business or curtailing an investment project would have no financial repercussions elsewhere in the corporation (e.g., ignores knowledge transfers). Strict financial measurement of many long-term investments, particularly in intangible assets, is virtually impossible.

Limitations of Present Value Measures Investments in R&D typically do not offer direct returns; their economic value is a strategic option to invest in new products and processes that may arise from R&D. Narrowly- defined DCF does not accurately value investments where there is significant strategic options value. (Merck has been at the forefront of applying strategic options theory to analyze investments in R&D).

Capital Market Approaches To Measuring Performance Market Value Added (MVA) Market Value less Total Investment Economic Value Added (EVA) Operating Profit (after tax) less annual capital costs; basically, this is economic profit Tobin’s q (Market Value/Book Value) a firm’s market value divided by its “replacement” cost The Market Value of the Firm - Current Value of all securities issued by the firm

Economic Value Added (EVA) Anheuser-Busch: Operating profit $1,756 million - taxes $617 million = $1,139 million WACC : 67% equity at 14.3% 33% debt at 5.2% 11.3% WACC Capital of $8 billion 11.3% * $8billion = $904 million $1,139 - $904 = $235 million EVA

Firms with the Highest Ratios of Market Value to Book Value (December 2005) Company Valuation ratio Country Yahoo! Japan 72.0 Japan Coca-Cola 7.8 US Colgate-Palmolive 20.8 Diageo 7.4 UK Glaxo Smith Kline 13.4 3M 7.3 Anheuser-Busch 12.6 Nokia 6.7 Finland eBay 11.2 Sanofi-Aventis 6.3 France SAP 10.8 Germany AstraZeneca 5.9 Yahoo! 10.7 Johnson & Johnson 5.7 Dell Computer 10.0 Boeing Sumitomo Mitsui Financial 8.8 Eli Lily 5.6 Procter & Gamble 8.4 Cisco Systems 5.5 Qualcomm 8.3 Roche Holding Switz. Schlumberger 8.2 L’Oreal 5.3 Unilever 8.1 Neth/UK Altria 5.2 PepsiCo 8.0 Novartis 5.1

Problems With Shareholder Wealth Maximization Under what conditions does “maximizing shareholder wealth” not make sense? When do we need to pay attention to other “stakeholders?” What are the social responsibilities of business to: Employees? Communities? Customers? The Issue: What are the “externalities,” and who bears the costs?